Happy tax day, everyone. 

Silicon Valley Bank put out a must-read study yesterday, examining returns from more than 850 VC funds in the U.S., looking specifically at returns by fund size.  And what they found out was that smaller funds do better than larger (>$250M) funds.

This won't be a surprise to some limited partners out there that I speak with, in my current dual role as both an LP and direct investor.  These LPs see smaller funds as being more focused and hungry.  As the SVB report states:

"Managers of [small] funds often have industry-specific expertise and focus on particular strategies or sectors compared to those of larger funds which usually target multiple stages and sectors.  Small funds tend to have a strong general partner commitment, which heightens the alignment of interests with limited partners and potentially increases investment discipline."

Smaller funds also are less susceptible to the kind of minimum check size restriction I described in my last post, with its implications for capital efficient investments.  I caught a little bit of grief from some colleagues at smaller funds after that post, because they thought I was talking about ALL venture capital firms getting caught up in check size inflation, but really I was only talking about the larger funds and their need to shovel dollars out the door.  Indeed, this SVB report adds further support to what I was talking about -- with smaller VC funds, you can put less dollars at work in a single investment and still get the kind of outsized return that can "make the fund".

So if smaller funds are so great, why don't they get more favored by LPs?

First of all, their performance is probably more volatile.  The SVB report focuses on the portion of funds that returned high multiples.  They state that smaller funds (those under $250M) were seven times more likely to provide a 3x return or better to LPs, than larger funds.  But that's 22% vs. 3% of each population, respectively, so the comparison leaves out a lot of lesser performances.  In their study, more than a third of smaller funds returned less than 1x, meaning they lost money for LPs.  Of course, in the pool of larger funds, more than HALF lost money!  But it's unclear from their report how many of each category lost a LOT of money versus losing a little bit.  LPs may be more willing to back a larger fund that has a more limited downside, than a smaller fund that could end up with more volatile results.

And what's also true is that smaller funds tend to have less experienced managers.  Most first-time funds will be under $250M, naturally.  And LPs are often leery of first-time managers.  I've spoken with some accomplished LPs who take an opposite approach, but generally speaking LPs have a difficult time determining the caliber of a first-time fund's managers, lacking a track record to refer to.  This obviously is related to the volatility/ downside point from above as well.

And furthermore, someone did the limited partner community a great disservice at one point by doing a study showing that top quartile performers among venture managers tend to stay top quartile performers over multiple funds.  I'm sure the study was totally valid and accurate, albeit backward-looking.  But what that study did was provide all the air cover any LP manager ever needed to simply pile capital into any big-name venture firm's latest huge fund.  It'll be interesting to me when that study is eventually revisited, to see if the effect remained valid over time, because I believe it provided fundraising momentum to larger funds that encouraged them to get unsustainably big and drift in their investment strategy, in some cases.  In the fund size retrenchment SVB identifies, I believe we're seeing the results of this.  But that having been said, there are certainly some large funds that have figured out how to make money at that scale -- as the SVB report shows, less than 10% of large venture funds returned 2x or better, but in that small group I bet there's some repeat performances by the same very few fund managers.

Finally, many LPs are of such a size that they really can't engage with small fund managers.  If you are managing a multibillion dollar pension fund with hundreds of millions of dollars allocated to private equity, can you really afford the time to identify, evaluate, and manage a $5M or $10M commitment to a small, specialist venture fund?  Some can, but many don't have the bandwidth to do so.  It's the LP analogy to the venture fund size dilemma I mentioned in the last post...

So smaller funds are, according to this SVB study, a better bet for LPs.  But LPs still find it hard to effectively engage with smaller funds, as a rule.

What does all of the above mean in cleantech in particular? 

It helps explain why cleantech-interested LPs have been drawn to larger cleantech funds, and large generalist funds who are getting active in cleantech.  This has exacerbated the shift over time toward more growth stage cleantech investing, and away from early stage cleantech investing (although there are some signs this shift has mitigated recently). 

The study suggests, however, that investing in smaller cleantech specialist funds may be a winning strategy for LPs -- if they have a rigorous way to effectively identify, evaluate, select and oversee those venture managers.  We'll have to wait and see if LPs actually do this more often.  But I believe they should.

And kudos to the team at SVB that did this study.